The
Corporate Life Cycle: Preface
In every discipline, practitioners
search for a framework that helps them explain the whys, the why nots and the
what ifs of that discipline. In corporate finance and valuation, we have seen
many such attempts to build universal theories, and in our view, the structure
that offers the most promise is the corporate life cycle, where companies go
through the cycle of being born, growing up, growing old and eventually
perishing. It is one that we find ourselves coming back to, repeatedly, as we try
to understand the behavior and misbehavior of businesses, differences across
investing perspectives and the allure of the next big thing.
The Corporate Life Cycle
The place
to start this journey is with an understanding of how companies age, and the
transitions they go through, and we try to do that in this picture:
A business start-up is like a baby, with a high mortality
rate, despite the care and attention paid to it. If a business makes it from
concept to product, it is already an exception and in young growth, it tries to
find a business model that works, with all logistical challenges involved. If
successful, it enters the high growth phase, with revenues accelerating, though
profits usually lag, and the business will require capital infusions to keep
growing. The most successful of these companies will be able to enjoy high
growth, where profits start to catch up to revenues and not only will these
businesses be able to self-fund, but you see the beginnings of cash flow
payoffs to owners and other capital providers. While the very best of these
mature businesses can extend this phase of glory, middle age eventually comes
to every business, with slowing growth, but solid profits and cash flows. Being
middle aged is far less exciting that being young, but after middle age comes
worse, as businesses age and find their markets shrinking and profits fading,
before they reach their ends. The corporate life cycle resembles the human life
cycle in its arc, and just as humans try to fend off aging and death with
plastic surgery and personal trainers, companies do the same, with consultants
and bankers offering them expensive and fruitless ways of staying young again.
Book Structure
In the
first part of this book, we describe the corporate life cycle, with the markers
to tell you where a company falls in the life cycle, and the forces that
determine why the shape and timing of life cycles vary across different types
of business. We also look at the transition points, as businesses transition
from one stage in the life cycle to the other, and the challenges that they
face in making these transitions.
In the
second part of the book, we use the corporate life cycle to explain how and why
the focus of a business should change as the company ages, with young companies
almost entirely centered on finding good investments, to mature companies
looking at changing financing mix and type, to declining companies deciding how
to return cash most efficiently. We use this framework to argue that the most
destructive acts in business occur when companies refuse to act their age, by
behaving in ways that are incompatible with where they are in the life cycle,
often spending large sums in this endeavor.
In part
three of the book, we use the corporate life cycle to illustrate the challenges
in valuing businesses, as they move through the life cycle. With young
companies, the biggest barriers are the absence of information on the working
of their business models, and the uncertainties about how these models will
evolve in the future. With mature companies, it is an over reliance on past
information, and the assumptions that what worked in the past will continue to
work in the future. With declining companies, it is the unwillingness to even
consider the possibility that companies can shrink over time and go out of
existence. In response, analysts often concoct short cuts and turn to pricing
companies, using pricing metrics, where the scalar changes from users and
subscribers for young companies, to earnings for mature businesses to book
value for declining firms.
In the
book’s fourth part, the corporate life cycle comes into play in explaining
differences in investment philosophies, and in particular, the divides between
growth and value investing. Value investing, at least in the form that it is
practiced today, with an emphasis on earnings and book value, will lead its
followers to mature companies, and growth investing’s focus will be on
companies earlier in the life cycle. In fact, the life cycle provides caveats
for each group on the risks in each of their philosophies, with growth
investors overpaying for what they perceive as young, growth companies, just
before they transition to middle age, and value investors pumping money into
mature companies, as they shift into decline.
In the
final part of the book, we look at other insights and extensions for managers,
that can come out of the corporate life cycle. We first look at what makes for
a great manager and argue that the one-size-fits-all narrative does not work,
since the skill sets needed to run a young, growth company are different from
those needed for a mature company. We also look at the dreams of rebirth and
reincarnation that excite managers at mature companies, and the lessons that
can be learned from the few companies that have succeeded and the many that
have failed. We finally examine how the shift away manufacturing to technology
have altered and shortened corporate life cycles, and why much of what we
accept as good business practice has not kept up with these changes.